Evaluating firm financial performance

1. Chapter 4
Evaluating a Firm’s Financial
Performance
Foundations of Finance
Arthur J. Keown John D. Martin
J. William Petty David F. Scott, Jr.

2. Chapter 4 Evaluating a Firm’s Performance
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Learning Objectives
After reading this chapter, you should
be able to:
§ Explain the purpose and importance
of financial analysis.
§ Calculate and use a comprehensive
set of measurements to evaluate
a company’s performance.
§ Describe the limitations of financial
ratio analysis.

3. Chapter 4 Evaluating a Firm’s Performance
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Principles Used in this
Chapter
• Principle 7: Managers Won’t Work the
Owners Unless it is their best
Interest.
• Principle 5: The Curse of Competitive
Markets – Why It’s Hard to Find
Exceptionally Profitable Markets.
• Principle 1: The Risk Return Trade-
Off – We Won’t Take on Additional
Risk Unless We Expect to Be
Compensated with Additional Return.

4. Chapter 4 Evaluating a Firm’s Performance
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Financial Ratios
• Ratios give us two ways of
making meaningful comparisons
of a firm’s financial data:
– Trends across time
– Comparisons with other firms’
ratios

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Uses of Financial Ratios
within the Firm
• Identify deficiencies in a firm’s
performance and take corrective
actions.
• Evaluate employees’ performance
and determine incentive
compensation.
• Compare the financial performance
of different divisions within the firm

6. Chapter 4 Evaluating a Firm’s Performance
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Uses of Financial Ratios
within the Firm
• Prepare financial projections,
both at the firm and division
levels.
• Understand the financial
performance of competitors
• Evaluate the financial condition
of a major supplier.

7. Chapter 4 Evaluating a Firm’s Performance
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Uses of Financial Ratios
Outside the Firm
• Lenders in deciding whether or not to
make a loan to a company.
• Credit-rating agencies in determining
a firm’s credit worthiness.
• Investors in deciding whether or not
to invest in a company.
• Major suppliers in deciding to sell
and grant credit terms to a company.

8. Chapter 4 Evaluating a Firm’s Performance
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Measuring Key Financial
Relationships
• How liquid is the firm?
• Is management generating adequate
operating profits on the firm’s
assets?
• How is the firm financing its assets?
• Is management providing a good
return on the capital provided by the
shareholders?
• Is the management team creating
shareholder value?

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How Liquid Is a Firm?
• Liquidity is the ability to have
cash available when needed to
meet its financial obligations
• Measured by two approaches:
– Comparing the firm’s assets that
are relatively liquid
– Examines the firm’s ability to
convert accounts receivables and
inventory into cash in a timely
basis

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Measuring Liquidity:
Approach 1
• Compare a firm’s current
assets with current liabilities
– Current Ratio
– Acid Test or Quick Ratio

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Current Ratio
• Compares cash and current assets
that should be converted into cash
during the year with the liabilities
that should be paid within the year
• Current assets/Current liabilities
Starbucks Example:
Current ratio= $922M / $591M = 1.67

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Acid Test or Quick Ratio
• Compares cash and current assets
(minus inventory) that should be
converted into cash during the year
with the liabilities that should be paid
within the year.
• Cash and accounts receivable/Current
liabilities
Starbucks Example
Quick Ratio=
($350M + $114M) / $591M =1.05

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Measuring Liquidity:
Approach 2
• Measures a firm’s ability to
convert accounts receivable
and inventory into cash
– Average Collection Period
– Accounts Receivable Turnover
– Inventory Turnover
– Cash Conversion Cycle

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Average Collection Period
• How long it takes to collect the firm’s
receivables
• Accounts receivable/(Annual credit
sales/365)
Starbucks Example:
Avg. Collection Period =
$114M / $1.68M= 68.1 days

15. Chapter 4 Evaluating a Firm’s Performance
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Accounts Receivable
Turnover
• How many times accounts receivable
are “rolled over” during a year
• Credit sales/Accounts receivable
Starbucks Example
Accounts Receivable Turnover =
$611M / $114M = 5.36X

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Inventory Turnover
• How many times is inventory rolled
over during the year?
• Cost of goods sold/Inventory
Starbucks Example
Inventory Turnover=
$3,207M / $342M = 9.38X

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Starbucks vs. Peer Group
Ratio Starbucks Peers
Current
Ratio
1.67 2.02
Quick
Ratio
1.05 1.54
Avg. Collection
Period
68.1 days 93 days
Accounts
Receivable
Turnover
5.36X 3.90X
Inventory
Turnover
9.38X 8.5X

18. Chapter 4 Evaluating a Firm’s Performance
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Is Management Generating Adequate
Operating Profits on the Firm’s
Assets?
• Operating Return on Assets
(OROA)
• Operating Profit Margin
• Total Asset Turnover
• Fixed Asset Turnover

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Operating Return on Assets
• Level of profits relative to total assets
• Operating return/Total assets
Starbucks Example
Operating Return On Assets =
$436M / $2,672M = .163 or 16.3%

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Operating Profit Margin
• Examines how effective the company
is managing its operations
• Operating profit/Sales
Starbucks Example
Operating Profit Margin =
$436M / $4,067M = .107 or 10.7%

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Total Asset Turnover
• How efficiently a firm is using its
assets in generating sales
• Sales/Total assets
Starbucks Example
Total Asset Turnover =
$4,076M / $2,672M = 1.53X

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Fixed Asset Turnover
• Examines investment in fixed assets
for sales being produced
• Sales/Fixed assets
Starbucks Example
Fixed Asset Turnover =
$4,076M / $1,750M = 2.33X

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Starbucks vs. Peer Group
Ratio Starbucks Peers
Operating
Return on
Assets
16.3% 14.9%
Operating Profit
Margin
10.7% 11.8%
Total Asset
Turnover
1.53X 1.26X
Fixed Asset
Turnover
2.33X 2.75X

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How Is the Firm Financing Its
Assets?
• Does the firm finance assets
more by debt of equity?
– Debt Ratio
– Times Interest Earned

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Debt Ratio
• What percentage of the firm’s
assets are financed by debt?
• Total debt/Total assets
Starbucks Example
Debt ratio =
$591M / $2,672M = .221 or 22.1%

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Times Interest Earned
• Examines the amount of operating
income available to service interest
payments
• Operating income/Interest
Starbucks Example
Times Interest Earned =
$436M / $3M = 145.3X

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Starbucks vs. Peer Group
Ratio Starbucks Peers
Debt Ratio 22.1% 25%
Times Interest
Earned
145.3X 46.0X

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Is Management Providing a Good
Return on the Capital Provided by the
Shareholders?
• Are the earnings available to
shareholders attractive
• Return on equity
• Net income/Common equity
Starbucks Example
Return on Equity
= $268M / $208M = .129 or 12.9%

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Starbucks vs. Peer Group
Ratio Starbucks Peers
Return on
Equity
12.9% 12.0%

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How Is Management Doing
Creating Shareholder Value?
• These ratios indicate what
investors think of
management’s past
performance and future
prospects. Two approaches:
– Price/Earnings ratio
– Price/Book ratio

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Price/Earnings Ratio
• Measures how much investors are
willing to pay for $1 of reported
earnings
• Price per share/Earnings per share
Starbucks Example
Price/Earnings Ratio =
$35.00 / $0.69 = 51X

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Price/Book Ratio
• Compares the market value of a
share of stock to the book value per
share of the reported equity on the
balance sheet
• Price per share/Equity book value per
share
Starbucks Example
Price/Book Ratio =
$35.00 / $5.32= 6.58X

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Starbucks vs. S&P Index
Price
Ratio Starbucks S&P
Price/Earnings
Ratio
51X 24X
Price/Book Ratio 6.58X 3X

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Economic Value Added (EVA)
• Measures a firm’s economic profit,
rather than accounting profit
• Recognizes a cost of equity and a cost
of debt
• EVA = (r-k) X C
where:
r = Operating return on assets
k = Total cost of capital
C = Amount of capital (Total Assets)
invested in the firm

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Limitations of Ratio Analysis
• Difficulty in identifying industry categories
or finding peers
• Published peer group or industry averages
are only approximations
• Accounting practices differ among firms
• Financial ratios can be too high or too low
• Industry averages may not provide a
desirable target ratio or norm
• Use of average account balances to offset
effects of seasonality